Monetary Policy

Bubbles the Fed Can't Ignore

The Federal Reserve is determined to keep interest rates super-low until the economy has fully recovered and people are back to work. But the central bank doesn’t want low, low rates to pump up dangerous asset bubbles by inducing investors to pursue higher yields.

Some markets have gotten so frothy lately that the Fed may be forced to tighten monetary policy earlier than it wants, just to keep bubbles from forming. That’s my takeaway from a story published today by Bloomberg News.

“If you’re too accommodative, the serpent in the market will come back and start speculating really quickly, and that’s what’s happened to some extent,” Lawrence McDonald, senior director for credit, sales, and trading at Newedge USA, told Bloomberg last week. “They’re watching that like a hawk.”

Some of the worrisome indications of risk-taking from the story:

• This year has seen record issuance of “covenant-light” loans—that is, ones that pay extra-high interest because they have been stripped of standard protections for lenders.

• Funds that purchase speculative-grade loans in the U.S., known as leveraged loans, attracted $2 billion last week, the second-biggest inflow on record.

• Junk-bond sales rose 24 percent through Aug. 9, compared to the same period a year ago.

• Sales of payment-in-kind, or PIK, notes, are on pace to top the 2012 level. PIK notes allow borrowers who can’t meet interest obligations to pay with additional debt.

What’s interesting about all those examples is that they aren’t the standard story of investors’ accepting low yields. Instead, they’re about different types of borrowing. In February, Federal Reserve Governor Jeremy Stein gave an important speech in which he said that exotic securities, such as PIK notes, which heighten the risk for lenders, tend to pop up at times when risk appetite increases.

Stein, who has taught at Harvard and MIT, put it in more academic terms in his February speech. He said “it is less obvious that increased risk appetite is as well summarized by reduced credit spreads. Rather, agents may prefer to accept their lowered returns via various subtler nonprice terms and subordination features.”

Stein said that one reason to use monetary policy to fight bubbles is that higher interest rates engineered by the Fed “gets in all of the cracks” that might be missed by supervision and regulation.

Federal Reserve Chairman Ben Bernanke is determined to keep rates low while the economy recovers but he, too, has acknowledged the risk of bubbly market behavior. In a May speech, he said that underlying vulnerabilities such as high levels of indebtedness and “maturity transformation”—i.e., borrowing short to lend long—”have the potential to magnify shocks to the financial system.”

Those signals from key Fed officials are what lead market observers to think that the Fed could end up tightening sooner than intended.

When to scale back bond-buying “seems to be a risk-management issue as opposed to a pure economic issue because the Fed hasn’t really met its mandates with respect to employment gains or with inflation,” Christopher Sullivan, chief investment officer at United Nations Federal Credit Union in New York, told Bloomberg.